Feedback Loop in Business – Identification and Parameters

Part I

The goal of accounting is to make continuous improvements in operation by monitoring economic results over a period of time. Any changes to economic value is analyzedfor impact and the source of the change. In effect, management is constantly tweaking the business to gain marginal improvements via financial results. This entire process is known as the feedback loop in business. It is an essential start-up principle for all business entrepreneurs. Any changes in operations are monitored for outcomes via financial results.

Science is the leader in using the feedback loop principle. They use a control group and a variable group to compare results and gauge the change. For those of you older than 35 you may have experienced the old stereo tuners where a fine tuning dial is adjusted to peak the antenna’s reception of a station. An analog meter indicates maximum power transfer. Turn the dial too much and the antenna power reception goes beyond maximum or peak and the power level drops; not enough tuning and the power level is too low. In accounting, it is the same concept. Power level is measured via financial results or profit.

There are several differences between the power meter and financial monitoring. First off, the power meter is instantaneous in output. Often the financial outcome from a change takes several months to pinpoint results. Secondly, there is a big difference between tuning in a radio station and possible bankrupting a company with a poor decision. So associating risk with the decision process is critical. Finally, patience is essential in business models and the feedback loop may produce positive initial results but long-term detrimental outcomes.

The feedback loop in business is a process. It has four distinct steps. Steps one and two involve identification of the change (variable) and documenting expected outcomes. Step three requires strict controls over the input of data. Step four is monitoring and interpreting the results. All four must be controlled to garner the value provided with the feedback loop method in business. The following two sections explain identification and expectations in more detail. Part II of this article series goes into detail related to data input and results monitoring.

Identification of a Variable

Economy of scale makes it easier for large businesses.to identify a variable and implement the change. Imagine a large retailer adding a new clothing line or a new store. Often economy of scale provides enough flexibility to change several variables at a time and still monitor the outcomes independently. But small business doesn’t really have this luxury. New variables frequently generate detrimental outcomes as they were not evaluated for risk or value. There are proper methods to identify and implement changes.

An excellent starting point is brain storming. This is when individuals sit down and openly discuss options. All options are recorded. The following is a short list of the typical variables presented at brainstorming sessions.

The list can go on and on, but it is always centered around the three fundamental concepts of business: people, process and product.

Once the list is created, it is time to evaluate risk and reward for the list.

As an example, adding a new division is extremely risky and there may be no reward. Even the the cost to add a division or integrate the company may be beyond the resources (capital, manpower or knowledge) available. The key is to identify a variable with low risk, minimal demand on resources and high reward. Once these types of variables are exhausted, more risky variables can be considered.

Once the variable is identified, the group must come to a consensus as to the outcome and any restrictions. The following are two examples:

RV Dealership

The dealership has been in business for over 20 years and is in the mode of tweaking the marketing and advertising campaigns. The sales and management team are meeting to discuss the idea of including an RV weekend show 80 miles away in the marketing schedule. The cost to conduct the show is estimated at $10,000 including show space, travel, lodging etc. The questioned posed to the group: ‘Is the risk ($10,000) worth the reward?’ Management explains that in order to consider the campaign successful, seven units would need to be sold. Five units is considered break even. The sales manager pulls the national studies on RV Expo’s and explains that the average number of serious buyers is less than 4%. This expo’s attendance was a little under 8,000 last year. This means there will only be 25 to 30 serious buyers over the three day event. There will be 23 dealers at the expo each with three to seven units on display. In effect, each dealer will get one sale assuming equal distribution of sales. So the group begins to discuss options. The following were documented:

Option 1 – Hand out a selective discount card for any potential customer from the show.

If a customer walks into the booth area and tours at least one unit, a discount card is handed to the potential customer for an additional 1% or $350 off the purchase price whichever is greater. They must purchase a unit within one year of the expo. Studies show that potential customers for RV’s explore first before committing to the RV lifestyle. This card is presented after the deal is signed for additional discounts. This provides two important pieces of feedback information. First it identifies the effectiveness of the expo to provide customers and two; it adds additional incentive to the customer to travel the distance to this dealership to explore and tour the facilities.

Option 2 – Change the presentation venue at the expo from selling RV’s to renting an RV for the next family vacation. The dealership has a rental program in existence and the gross profit is around $500 per one week rental. The ideal goal is to get more than 20 customers to rent for a week or weekend and make their reservations early.

0ption 3 – Go big and get a customer to purchase one of the large motorized homes.

The booth space would have to be one of the larger spots in the center of the expo’s arena adding $3,000 to the cost. The typical margin on a large unit is $8,000 to $16,000 depending on the deal.

One of the salesmen (a new junior sales rep) reminds everyone that the real goal of the dealership is to gain loyal customers for life. These customers will purchase their units and camping gear at the retail center. In addition, these customers will need maintenance and repairs via the service department; most importantly, refer future customers. The sales reps are ambassadors for the RV lifestyle and the dealership.

The group agrees the expo serves the purpose of exposing potential customers to the RV lifestyle and the advantages of this dealership over other dealerships. They decide on Option 2 but use new inventory for display purposes. Any customer looking at a unit and registering would receive the special discount card.

Custom Engineering

Custom Engineering builds manufacturing equipment for the upper mid-west. This includes packaging systems, production and pre-production types of equipment. Currently all equipment is either mechanical or pneumatic (air) driven. Current products include cooking equipment, conveyors, boxing and stacking devices. The company employs 40 people and management desires to increase gross profit with higher margins. Management and the engineering staff gather together to create ideas for additional products with higher markups. Here are the results:

Idea #1 – Use existing knowledge to create a new product line focused on farming equipment including balers, tank transfer systems, separators and tools.

Idea #2 – Expand the knowledge base to include electromagnetic and electronic systems. In effect increase the precision of existing systems sold thus demanding higher margins for additional quality and capacity.

Idea number three is appealing because it can be immediate and short term results will be fruitful. But the long-term quality issue for this business is detrimental to the family name. Idea number one is intriguing because it uses existing knowledge for an entire new division of products. However, the gross margin will not increase due to a similar markup. The goal is to increase overall gross margins with greater markups.

Idea number two solves this markup issue. It will require employing well educated electronic engineers but the markups can be significantly higher because existing systems can be modified to produce greater accuracy improving overall quality.

Now that there is consensus from the group, it is time to develop the expected results (outcomes).

Expected Outcomes

This step is most frequently skipped by small business because it is just assumed the variable selected and agreed to by all parties will automatically be successful. The reality is quite different. Without documenting the expected outcomes there is no standard to define peak performance. The group must agree to the parameters as to what is expected.

If the group sets the bar too high, the variable change will be defined as too risky when the goal is not met. This affects future decision models and ultimately long-term performance. If the outcomes are too low, similar changes in the future will fail to generate real value for the company. So reasonable expectations are warranted by the team.

Going back to the two examples, here are their expected outcomes:

RV Dealership

The group came up with the following outcomes (parameters) as their definition of breakeven and good performance for the expo weekend.

The group agreed that the most time consuming function will be explaining and issuing discount cards to potential customers. As a function of issuing the cards, an explanation pamphlet will accompany the card. The idea is to get potential customers to go the extra distance to visit the dealership.

Because of the complexity of the rental program, reservations are a sign of a strong interest. Once the customer reserves a period of time, a reservation contract is e-mailed and the reservation is good for 30 days without a deposit. Reservation contracts permanently reserve the unit because the customer pays a nonrefundable deposit. Full payment must be received 30 days prior to actual use of the unit.

The e-mail registrations are designed to send the customer a monthly newsletter and coupons for deals at the dealership.

The icing on the cake is an actual sale of a unit that weekend.

Custom Engineering

The management and engineering team agree that the expansion of engineering will take time to fully implement and create products that will generate results. The team agrees that real financial results will not occur for at least two years. The following is their projected timeline for implementation.

The team further agrees that the initial portfolio of engineers is three and that within three years, a total of six should be on staff including service and repair technicians. Initial feedback from customers for greater precision include demand for packaging (weight, size and color), separators (metallic particles, size and measurement) and temperature (heat, cold, duration and timing).

The team agrees that packaging equipment for weight and size should be the initial target for electronic measurement and accuracy. This particular line of custom engineered equipment is the most in demand and any existing customer will desire improvements. So a goal of a working packaging line for a particular food product is for 19 months out as the first initial measurement of success. From that point on, the measurement of success is reported via financial statements.

Part II of this series explores the accounting function in the feedback loop.

Summary

The feedback loop in business is a process of monitoring changes to production and operations. It involves four distinct steps. The first two are identification of a single variable and the corresponding outcomes. The feedback loop can be instantaneous or drawn out over several years to determine success. Act on Knowledge.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.

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I spent 12 Years as a Certified Public Accountant,
Over 20 Years of Practice in Accounting and Consulting,
Controller in Management of Closely Held Operations,
Masters of Science in Accounting,
Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns

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